WENZHOU, China — This bustling city of seven million people on China’s coast was once a model of private entrepreneurship, known for its innovative ways of building businesses and amassing fortunes.

This story first appeared in the November 14, 2011 issue of WWD. Subscribe Today.

Today, Wenzhou stands as a warning, its complex network of private loans having collapsed, leaving a long list of bankrupt businesses and shuttered factories in its wake. A manufacturing hub in eastern China’s Zhejiang province — one of the country’s two main apparel and textile production centers — Wenzhou is home to more private companies than most cities in China and has been looked upon in years past with envy for its private, underground lending system.

Established businesspeople and more unscrupulous lenders lent money to those wanting to build enterprises and who did not have enough capital to get bank loans. Over the course of many years, the shadow lending industry grew and wealth expanded in Wenzhou.

Now, it seems the Wenzhou model may have been a house of cards waiting to collapse. Economists are debating just how widespread the shaky loan system is across China, with some estimates saying more than 5 percent of business loans in the country are private, not conducted or regulated through banks.

When Wenzhou’s economy started to falter on lower demand from exporters in 2008, the economic situation tightened and so did credit. But for more than two years, businesses managed to keep going through private lending, expanding somewhat and filling factory orders by taking credit from private lenders. Those lenders charge interest rates far higher than bank loans, however, and this year, factory owners found themselves unable to pay back massive piles of debt.

Those tracking the Wenzhou credit scandal locally estimated that hundreds of businesses and factories have shut down, and at least 80 company bosses fled town to escape their debts this spring, summer and fall. Many have now returned, to promises from the central government that economic planners will do more to help smaller and medium-sized companies. Even Premier Wen Jiabao paid a visit to the stricken city this fall, pledging to shore up the credit system for smaller businesses so they can survive.

But local businesspeople report factories sitting idle, credit nonexistent and business all but dead.

“For us, the normal people, things haven’t changed that much,” said Wang Qin, who owns a downtown shop selling kitchen appliances. “Prices are going up and people are buying less, but we can adapt.”

The discarded symbols of Wenzhou’s wealth tell a different story about how the credit crisis has affected the city’s many newly rich. Across town, secondhand car markets are chock full of luxury vehicles, on sale for half the market value or less. On one corner, a stretch Hummer limousine stands dusty and for sale, while in various other car lots, Porsches, Audis and Mercedes line the pavement. One saleswoman at a used car lot said prices are low and cars are plentiful. In other words, Wenzhou might be the best place to get a good deal on a used luxury car.

It’s no longer the best place for manufacturing, according to factory owners on the outskirts of town. Several managers who ran manufacturing businesses through the boom years report it’s no longer possible to produce. They have orders, they say, but are unable to get any bank or private credit to buy raw materials and pay workers.

“We just want the government to formalize the private lending system,” said one steel boss who requested anonymity. “I think we can work things out from there.”

Zhou Dewen, head of Wenzhou’s small- and medium-sized business association, said it’s critical that the central government recognize Wenzhou’s predicament and act accordingly. A majority of the city’s businesses are not large or state-owned enterprises, he said. Their survival is critical to the economic health of the region. The group has started its own emergency lending pool in the interim.

“We cannot rely on government efforts exclusively, we should try to save ourselves,” said Zhou.

“Most companies are operating and recovering from the panic mode gradually,” he said. “But the general environment for small and medium enterprises cannot be changed overnight.”

Perhaps the bigger question emerging from Wenzhou is what the collapse of the private credit example means for the rest of China. Shanghai-based economist Andy Xie said the model appears widespread, which would be bad news for the economic base of China. Without accurate, detailed data, it’s difficult to say for certain. But smaller businesses across China are reporting cutbacks and financial problems.

“The size of the market is impossible to estimate,” Xie warned recently. “If the slowdown in bank deposit growth partly reflects this phenomenon, it could be several trillion yuan in size. When it bursts, it may lead to significant social instability.”

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